Five percent of gold juniors deliver 90% of the performance - Cook and Rule

Success seldom comes true in the risky junior exploration sector but investors may have driven some junior gold stock prices up into multiples of their true value. Gold Report interview.

KENWOOD, CA - Author: Karen Roche

Posted: Thursday , 16 Jun 2011

The Gold Report:The performance gap between equities and their underlying commodities has been especially noteworthy with gold. Brent, you wrote recently that the gold price has outperformed mid-tier gold mining stocks since 2005, with the price of gold up 190% versus 70%-90% for gold equities. Is this because investors can buy gold more easily now, or are some systemic reasons behind the equities' underperformance?

Brent Cook: Several dynamics are involved. Certainly one is that you can now buy gold through exchange traded funds (ETFs). That is a very simple bet on the gold price that does not carry all the baggage that comes with mining the stuff. That baggage includes the almost universal underestimation of development and mining costs published by mining companies, engineering firms and equity analysts. Capital costs are rising sharply due to the basic increase in cement, steel, fuel and everything else that goes into building a mine. Production costs are going up for many of the same reasons, plus rising labor costs. Qualified and experienced people are hard to come by and overworked. The result is lower-quality engineering studies and misses on cost estimates.

Additionally, with the higher gold price, companies are mining lower-grade ore, which cuts down on margin per ounce produced. Then, we have the almost continual issuance of stock whenever a brokerage firm sees a chance to make a commission. From my dealings with value-oriented funds, this continual dilution from mining companies has been very frustrating and perplexing. Given everything I mentioned, it's not hard to see why the leverage we expected in gold equities at a $1,500 price hasn't materialized.

TGR: So, will we ever see the leverage?

BC: Now is probably a good time to look at mid- to large-tier companies that have good production profiles at the lower end of the production cash costs and high cash flow per share.

TGR: What's your opinion on that, Rick?

Rick Rule: With regard to the juniors, everybody looks to the 1970s as the analogue, when we had that huge parabolic rise. That won't happen again. We won't see the circumstances we had in the mid- and late-1970s, when there was a shortage of stock. The industry now has the infrastructure to print paper-stock certificates-faster than demand can ever develop.

Brent nailed the reasons for the underperformance. People don't have to invest in gold stocks; they can invest in a gold proxy in the stock market. The underperformance has been disgusting, frankly, and investors are punishing the industry deservedly. The basic product going from $250-$1,500 an ounce without margins going parabolic is truly sick.

TGR: Given that, why should anyone invest in a junior at this time?

RR: Performance in the junior sector takes place in a very small subset; 5% of them deliver 90% of the performance. The performance delivered by that 5% is so spectacular that it adds credibility to a sector that, otherwise, would have none. People who have access to information, who subscribe to services such as The Gold Report or Brent's Exploration Insights, can do very well because performance is simply a factor of segregating-not buying the sector, but buying the best companies.

TGR: You've both talked about being more selective with juniors. And Brent, you've indicated that many investors go in without even really knowing what the geologists are saying. But geology is science; how can a lay investor really understand the difference between a real ore body and moose pasture?

BC: To get an edge, you have to go to someone who understands what a drill hole means, what an ore deposit is and isn't and, most importantly, when it is and isn't an ore body. It's really important to have advice from your broker, a newsletter writer or someone in the industry that has the experience to judge a property and the people running a company.

TGR: Wouldn't the geologist associated with the company be that expert?

BC: Not really. You need someone who's truly independent. In my newsletter, I write about what I'm doing with my money and that's it. I don't get paid by companies for recommending or promoting them. When I make a mistake, it's obvious and costs me money. That's my approach. Geologists working for a company, right or wrong, are also drinking their own Kool-Aid.

TGR: Rick, other than Brent, who do you rely on for the geology component?

RR: In order to compete, it's important for investors to educate themselves better than their peers, which isn't hard because most of those peers are completely uneducated, so they understand the nature of the information that someone like Brent gives them. They have to know a bit about geology to be able to give a relevant assignment to the professional they hire.

We employ geologists, so some of it's internal. We also offer an educational service called Mining Investment College that we put together in conjunction with the Colorado School in 1996. In terms of technical newsletters, Brent's is probably the best in the business.

TGR: If considering the geology is one component in being selective, what other factors might make a junior investment outstanding?

BC: Clearly, management. These companies tend to be very small. We're talking sub-$50-million market capitalizations and often sub-$10M market caps. The people running the company must be competent. If it's an exploration company, it needs exploration expertise. Management also should be committed, in terms of owning stock purchased in financings and not just the first seed round. Share structure is certainly key; what good is a 1,000% rise in a company's market capitalization if it's accompanied by a 1,000% increase in shares issued? Company management has to know what it's looking for.

That simple concept is very, very important and you would be surprised at how many companies really don't have a clue about what the deposit they are looking for looks like-and even worse, no idea of what its value might be when all the exploration, development and mining costs are thrown in. Management also has to bail out of a property as soon as it doesn't look like what the company's after; 95% or more of the time, a project finally fails. That's just the way it is in exploration. So, it is critical that a company cut its losses as soon as possible and move on. You can't do so if you don't even know what the thing you are looking for looks like or how to value it.

TGR: In terms of management, is it the luck of the draw when you put the drill hole in?

BC: No. Some people consistently perform better, find deposits or at least get into good districts, while others continually stumble.

RR: Again, Brent nailed it. It gets down to people, people, people. Four reasons why good people matter:

Prospectors who find an unusually good anomaly tend to take it to A-level promoters first, so the people with track records will see better stuff.

Good people have a history of being able to separate the wheat from the chaff.

In a bad market, good people can keep a good project without going broke.

Because of their track record, their cost of capital is lower and they have a better chance of being successful.

TGR:What other factors should investors consider?

RR: After people, scale is incredibly important. You take extraordinary risks in this business, so you have to search for extraordinary reward. The idea that somebody will make a bunch of money on a 200,000 ounce (200 Koz.) gold deposit and use cash flow from that to avoid dilution-you know, the business-building thing doesn't work. If you're taking big, big risks you have to look for big, big rewards.

TGR: But if you're looking for big, big risks and only 5% of the deposits pay off, have you reduced that 5% to something less?

RR: Oh, it's much worse than that. Only 5% of the management teams are any good. When Brent and I went to school, admittedly a long time ago, we were taught that the odds against a deposit becoming a mine were somewhere between 3,000:1 and 5,000:1. So, it isn't 5%. It's an infinitesimally smaller number.

TGR: When a company has an unusually good project, does it typically bring that to another who can finance or manage it?

RR: Yes. Finance it and manage it.

TGR: Rick, for quite some time now, you've been hounding investors about how to handle volatility. In a nutshell, do they have to become more active traders, or just more emotionally prepared to ride it out?

RR: The latter. Trading isn't a strategy, and it isn't a defense. You have to trade right. You have to be prepared and disciplined in order to trade right. Investors respond to volatility in predictable, but strange, ways. When the market goes up 30% for no reason other than volatility, investors tend to become aggressive and want to buy more. By contrast, they panic and sell when the market goes down 30%. Most investors respond to volatility by selling low and buying high, panicking the wrong way in both directions.

TGR: But to capitalize on volatility, wouldn't an investor take some profits when the stock goes up and wait for it to go down before starting to buy back in? Wouldn't that make me a more active investor?

RR: What you said was the right thing-buy in panics and sell in manias. Most speculators, however, buy in manias and sell in panics. They get the timing pretty good, they just make the wrong decision twice.

BC: I think that's because they don't really know what they own. Retail investors tend to end up with portfolios of anywhere from 20-100 stocks and don't really remember why they bought them, who recommended them, what they're worth or even what their symbols are. When something bad happens, they sell everything-the good with the bad-because they don't have a sense of the underlying value. If they did, they'd know which stock to buy when it drops and which to sell when it goes up, at least in a perfect world.

TGR: Brent, in The Gold Report last month, you said that given the two-year bull run, junior valuations are quite high and don't reflect the inherent risks in exploration and mining. You advised caution as reality sets in. And Rick, at a recent Casey Conference, you said that the market is seriously overvalued but the rally will continue. So, are you two in agreement or do we have a difference of opinion here?

RR: I suspect that Brent and I aren't even a degree apart on a 360-degree sphere, in the context of relative valuations and the risk-adjusted net present value (NPV) in exploration.

BC: Yeah. I think Rick and I see these things from the same vantage point, albeit his is a bit more luxurious than mine. Most of these companies really aren't worth much if you put a monetary value on their properties. For the most part, junior exploration companies have properties with geochemical anomalies scattered around the world. These aren't really assets, but rather liabilities that will take a lot of money to turn into an asset if that anomaly is the rare exception that proves to be economic. Until that happens, it's shareholder money going into the hole in the ground that has to be replaced.

RR: I could probably quadruple my income as a broker by being more generous with the valuations I assign companies in private placements. Brent could easily double or triple his subscriber base if he could allow himself to be more aggressive. But in a universe of 4,000 stocks, he probably has 8 or 9 on the buy list. Particularly in a bull market, subscribers don't like those constraints. They want to be allowed to dream. But I think that our own mutual perceptions of the value in the market are strong enough that we constrain our own income by constraining the sphere of things that we're willing to waste other people's money on.

TGR: But if it's a bull market and it's going to rally, you're making-not wasting-money.

RR: Yes. But only those who have the good sense to sell, an extraordinary minority, will make money. That skill-understanding the value of a story in a market-differs from psychoanalysis. That's not something I do. If that's the sort of trade you want to make, go to somebody like Jim Dines of The Dines Letter.He's a market psychologist and a journalist. Don't go to a geologist like Brent or a pawnbroker like me.

TGR: Why do you call yourself a "pawnbroker?"

RR: I try and figure out what something is worth and buy it at a discount to that value. I don't care about the value of a story in a market. I never buy a stock with a view that I'm going to sell it to some other investor at a higher price. I always buy stock representing fractional ownership in a business that I think I'm going to sell after value that I recognize as inherent is recognized by a knowledgeable trade buyer.

TGR: At the Casey Conference, you also said that you expect another downturn because the market pre-conditions to 2008 still exist and that panic markets offer the best opportunities (i.e., value investing), which you were just talking about. Putting all of that together, are you suggesting that investors cash out now and wait for the panic to buy?

RR: For some speculators, the answer is yes. My partnerships, which represent the best work I do, are about 35% in cash at present. That isn't a consequence of a market call as much as the fact that, in most investment decisions, my fear overwhelms my greed.

For those who don't have the discipline not to panic, this would be a wonderful market to exit-despite the fact that the Venture Exchange is probably down 20%-25%. People don't understand that the magnitudes of declines experienced in this market have been around for a long time. I suspect that the real top-to-bottom downturn in this market-and it will come-will be a waterfall decline. Certainly the 1998-2002 market saw a 95% decline, and I suspect the 1988-1993 market represented another 95% decline. The 1982-1985 market represented a 95% decline. I don't know that we'll have a decline like that in this market, but it wouldn't surprise me at all to see it decline by 50% if we have another confidence-in-liquidity crisis, such as that in 2008. Is that a prediction? No. But, is that set of circumstances unlikely? No.

People have to be psychologically and financially prepared to endure incredible volatility in this sector. A secular decline of 50% in a cyclical bull market doesn't feel like something that might be short term to the person who's experiencing it.

TGR: Brent, you've said that we've entered a period when the metals supply as a factor of time can no longer keep up with demand as a factor of time. Would you elaborate on that a bit?

BC: Whether it slows down or speeds up, the demand for metal is something we can't keep up with physically. We can't physically build all the deposits we'll need to replace what's being depleted and to accommodate future demand. It's a function of the current environment to find, delineate, develop and exploit an ore deposit. The permitting, environmental and social realities slow the process down but the interesting point of that statement is that we flat out don't have the people to actualize the mines that are in the planning stage. We just don't have the people. There aren't enough engineering firms to design and build the mines.

Something like 230 projects with capital costs exceeding $400M are scheduled to be put into production over the next six to seven years. We can physically build only 20-30 of them a year at best, so there's a real bottleneck. This situation will keep the current metals bull market going. So, long term, this is a good place to be; but as Rick pointed out, we've had a really good run. High-risk mining and exploration plays are overvalued, particularly in the junior sector, where success is not guaranteed-yet success is being priced into these companies at multiples. Outfits with drill holes in the middle of nowhere are selling for $700M. That's assuming an awful lot of success.

RR: Those development-stage projects Brent referred to aren't a problem right now because debt capital is currently available. The capital markets shut down to the mining business from late-2007 through 2009. Another crisis in confidence that delays those projects by three or four years, because miners couldn't raise the money to build them, would present a whole range of interesting situations for the speculator.

TGR: Brent, you said earlier that with the juniors being so overvalued, this might be a good time to look at mid-cap and large-cap plays.

BC: I still recommend smaller-sized companies, but with tangible assets, in terms of resources in the ground that I believe will be economic.

I expect, but certainly don't know, pure exploration plays to get a lot cheaper. If this summer and fall go as badly as it looks like they will to me now, we'll be able to pick up discoveries for less than their current prices because people won't be buying drill holes. I am hoping most of the market players won't recognize a good drill hole or property from a bad one.

TGR: What will drive prices down?

BC: The market's been going really well for two full years. Most people in this industry recognize their chances of success really aren't that good. The smart money has been pulling out; and if the bigger markets fall off the way, and it looks like they will, it's going to really hit the riskier side of the sector- junior miners. But if Rick and I are right about the longer-term outlook for metals getting into potential economic discoveries on the cheap, it sounds quite good.

TGR: Yes, but wouldn't a high-quality group be able to weather a downturn or not experience as much of a downturn?

RR: Yes. But how many speculators have the guts to ride something down and ride it back? Numerous times in my life, fortunately or unfortunately, I've made that roundtrip. In the face of a 50%-60% decline, people who believe themselves to be truly in the business must be able to check their premise and either double down or say, "I made a mistake and I'm going to lose half." It's a very difficult discipline in either context. Many people who paid $1 for a stock say they can't sell at $0.50 because they'll lose 50%. That's wrong. They've already lost 50%; the question is: What are they going to do with the remaining 50%? If they were right to buy it at $1 and it's selling it at $0.50, they have to buy more at $0.50.

I've been relatively successful in the investment business because I think I understand the full panoply of risks and when I go into a stock, I do so in very sober fashion. If you speculate in exploration, you have to expect failure.

TGR: Expect to fail?

RR: You have to know you'll make 10 or 11 mistakes out of 20 decisions. But if you can limit your losses to 20% or 30%-in other words, once you recognize that your thesis is incorrect, you sell a stock irrespective of loss-on the odd company, you're going to make 10:1 or 20:1. That's the beautiful thing about exploration. A twentybagger amortizes so many mistakes that, over time, you can do as well as I have from a portfolio point of view.

TGR: Performances like that certainly are worth celebrating.

RR: They are, but you have to be extremely disciplined, both with your expectations and with your reactions to reality, and go into the stock in a very sober fashion.

Renowned exploration analyst, geologist and author of the weeklyExploration Insights-a mining and exploration investment newsletter focused on early discovery, high-reward opportunities primarily among select junior mining and exploration companies-Brent Cook has devoted 30+ years to providing economic and geologic evaluations to major mining companies, resource funds and investors. A 1978 graduate of Utah State University (BS in geology), he's worked in more than 60 countries on virtually every mineral deposit type and on projects from the conceptual stage through to detailed technical and financial modeling related to mine development and production. His hallmarks include applying rigorous factual analysis to the projects and companies he examines and augmenting his analysis with onsite field evaluations. Brent was principal mining and exploration analyst to Global Resource Investments from 1997 until 2002 and since then has served as an outside analyst and advisor to several investment funds and high net-worth individuals.

Founder of Global Resource Investments Ltd., Rick Rule is a well-recognized expert whose company has built a stellar reputation for providing investment advice and brokerage services to high net-worth individuals, institutional investors and corporate entities worldwide and for taking advantage of global opportunities in the mining, oil and gas, alternative energy, agriculture, forest products and water industries. Rick has been principally involved in natural resource-security investments from the start of his career in the securities business in 1974. Since establishing Global in 1994, he's also been particularly active in private placement markets, having originated and participated in hundreds of debt and equity transactions with public, pre-public and private companies. Earlier this year, Rick closed a landmark deal with Eric Sprott, another famous powerhouse in the natural resources arena. With GRI now a wholly owned subsidiary, Sprott, Inc. manages a portfolio of small-cap resource investments worth more than CAD$8 billion and boasts a workforce of more than 130 professionals in Canada and the U.S.